What are index futures & how to read forward signals from them?

Equity indices are formed by a fixed number of constituent stocks to reflect investor sentiment in the economy. An index can also be sector-specific – Nifty Bank, Nifty Metal, Nifty FMCG etc. which reflect investor sentiment in a particular industry.

Now, futures are derivative contracts that obligate the parties to transact an asset at a pre-determined future date and price. Such contracts require the buyer to purchase or the seller to sell an underlying asset at a pre-set price, regardless of the current market price on the date of expiry.

In India, Nifty and Bank Nifty are most traded index futures currently. Traders read volume, price and open interest data in these contracts to draw out critical signals on the possible forward movement on the market.

Options (Calls & Puts) for an index are also available to trade, which can also be clubbed in such an analysis to get a better reading.

In index futures, traders read the open interest data to track investor sentiment around an index. Open interest reflect the outstanding positions, which are supposed to be squared off on or before expiry. A rise in price with rise in open interest in a security shows the confidence of the new participants or existing participants and they increase the chances of a possible rise in the price of the underlying. On the other hand, if the price falls with a rise in open interest, it would suggest growing confidence among the short sellers that the price of the underlying will go down.

When open interest falls, it shows loss of investor interest in the current trend. If the price rises with a fall in open interest, it would suggest the shorts are getting covered, whereas a fall in price with a fall in open interest would mean longs are exiting positions and the uptrend may not continue.

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This can be easily understand from the table below:

Price Open Interest Position View
Up Up Long Uptrend may continue
Down Up Short Downtrend may continue
Up Down Short Covering Chances of reversal from downtrend
Down Down Long Unwinding Chances of reversal from uptrend

Another parameter to look at is the basis gap, which define the different between the cash (spot level) and futures. The basis gap can be calculated by subtracting the spot price from future price. A positive basis defines bullishness in the market as it reflects a positive view for the near term.

In simple terms, when the market is anticipating bullishness in the future, the future price will always be trading above the spot price. If the market expects bad news or show bearishness for the immediate future, then it will trade below the spot price, which will lead to a negative basis gap. These are two basic yet effective parameters from the futures market to track the index.

(DK Aggarwal is the CMD of SMC Investment and Advisors)



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